This is a model of wealth distribution based on trade theory. As originally refined by Ricardo, trade theory shows that if two nations have different endowments of resources and labor, they can both gain from trade-even if one is generally more productive than the other. (In Ricardo's example, Portugal and England trade wine for cloth, with Portugal having a "comparative advantage" in wine, and England in cloth.)

I applied the same principles to individuals and to firms. Richer individuals and larger firms have a higher ratio of assets (natural resources and capital) to labor. They "trade" with poorer individuals and smaller firms-by renting resources, lending capital, and hiring labor. But just as trading nations face shipping costs, tariffs and other barriers, trading individuals and firms face "transaction costs." Transaction costs include the usual taxes and fees incident on any deal, but also the cost of monitoring and enforcement. In particular, owners or managers of wealth must spend some of their personal time supervising, or be ripped off. This is the so-called "principal-agent" problem, which arises because no two person's interests ever completely coincide.

Trade theory applied to distribution yields some striking predictions: Most dramatically, inequality of wealth reduces overall economic productivity and slows growth; the greater the inequality or higher the transaction costs, the more severe the impact. Other predictions include: Because richer persons and larger firms have a higher ratio of assets to labor, they invest more in education and training, and pay higher wages. They enjoy a comparative advantage in owning better quality natural resources, and more capital-intensive industries. Social class also arises naturally, as richer persons find a comparative advantage in entering high-paid high-skilled occupations and in sticking together to reduce costs of monitoring; vice versa for poorer persons.

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Mary M. "Polly" Cleveland
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Revised: 3/05/2011